If you thought you left your tax troubles behind at retirement, think again. There are still plenty of tax minefields for retirees to avoid. For instance, you run the risk that the Social Security benefits you receive will be subject to federal income tax. And the higher your income for the year is, the greater the tax.
The IRS offers a safe haven for retirees who have "provisional income" (PI) below a specified level. If you stay below the threshold, you don't have to pay any tax on your benefits. But watch out if you cross into the "50% zone" for income above the threshold and further into the "85% zone" above a second threshold. The taxes that you may owe are computed on line 20b of your Form 1040.
There's no tax if your PI is under $25,000 for single filers and $32,000 for joint filers. For this purpose, PI is the total of (1) your adjusted gross income (AGI); (2) your tax-exempt interest income (usually from municipal bonds); and (3) one-half of the Social Security benefits you received during the year. Suppose you're a joint filer with an AGI of $25,000, $1,000 in municipal bond income, and you got $10,000 in Social Security benefits—your total PI of $31,000 ($25,000 + $1,000 + $5,000) is under the threshold.
However, if your PI exceeds this first threshold, you're taxed either on one-half of your benefits or 50% of the amount of your PI that exceeds the threshold, whichever is less. So if a single filer has a PI of $30,000, including $10,000 in Social Security benefits, his or her tax would be based on 50% of the PI above the threshold—half of $5,000, or $2,500—rather than the $5,000 representing half of the Social Security benefits.
But there's a second threshold that can result in more of your benefits being taxed. If your PI is greater than $34,000 for single filers or $44,000 for joint filers, you're swept into the 85% zone and may be taxed on 85% of your benefits. But that's it. No more than 85% of your benefits will ever be taxed.
When it makes sense, take steps to reduce your PI to reduce or completely avoid the tax on Social Security benefits. A few possibilities are:
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